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Is EVA an Effective Performance Measure; Evidence from Colombo Stock

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Article in Asian Journal of Finance & Accounting · December 2017

DOI: 10.5296/ajfa.v9i2.12032

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 Asian Journal of Finance & Accounting
ISSN 1946-052X
2017, Vol. 9, No. 2

Is EVA an Effective Performance Measure

Evidence from Colombo Stock Exchange, Sri Lanka

Yathra Mullage Chithrasheeli Gunaratne

Department of Management Sciences, Faculty of Management
UvaWellassa University of Sri Lanka, Badulla, Sri Lanka
Tel: 94-718-285-587 E-mail: gunaratneymc@gmail.com

Received: Oct. 23, 2017 Accepted: Dec. 1, 2017 Published: December 1, 2017
doi:10.5296/ajfa.v9i2.12032 URL: https://doi.org/10.5296/ajfa.v9i2.12032

Abstract
The aim of this study is to explore the relationship between Economic Value Added (EVA)
and stock return in Sri Lanka. The study sample consists of 1695 firm year observations
covering 113 public limited companies listed in Colombo Stock Exchange (CSE) for 15 years
period from 1999 to 2013. This study was based on secondary data, collected from the CSE
data library and the published financial statements of companies considered in the sample.
Pearson Correlation Coefficient analysis and the fixed effect model of Panel data Regression
analysis techniques were used as the statistical techniques to analyze data. The statistical
analysis revealed that there is no significant positive relationship between EVA and stock
return in Sri Lanka. Contrary to the arguments of EVA proponents, the researcher suggests
the market participants of Colombo Stock Exchange to select other performance measures
instead of EVA to make rational economic decisions.
Keywords: EVA, Performance measure, Panel data, Stock Return, CSE

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1. Introduction

Performance measurement of corporations is an important and essential task for any business
entity. The Economic Value Added (EVA) is one of the financial performance measurement
technique used by corporations worldwide. It is a value based performance measure which
goes beyond the rate of return and considers the cost of equity capital as well. It measures the
earnings of a company after providing for the cost of equity capital. According to Paliam
(2006), the EVA is an incarnation of the underlying residual income (RI) concept. Pandey
(2005) defined the EVA as net earnings (PAT) in excess of the charges (cost) for
shareholders’ invested capital (Equity).
This technique was initially developed by Stern Stewart & Company consultant group in
1980s (Stern, 1985; Stewart, 1991; Stern, Stewart and Chew, 1995; Ferguson, Rentzler and
Yu, 2005; Paliam, 2006; Kumar and Sharma, 2011). They introduced this concept to the
business world and argued that this is the superior performance measurement technique
compared to other performance measures available. Later some other scholars and
practitioners have empirically supported the argument of EVA proponents and many
corporations have adopted EVA as a technique used in firm performance measurement and
portfolio selections decisions (Teitelbaum,1997) considering that the EVA as one of the best
techniques that measures the true economic profit of a firm (Swaroop and Chandra, 2009).
The EVA is the most researched value based performance measure in the academic literature.
However, having identified that many scholars confirmed the findings of EVA promoters (for
example; O’Byrne, 1996; Uyemura, Kantor and Petit, 1996; Milunovich and Tsuei,1996;
Lehn and Makhija,1997; Herzberg,1998; and Forker and Powell, 2004;Worthington and
West , 2004; Haddad, 2012) there are sufficient number of researchers (Peterson and,
Peterson, 1996; Appleby, 1997; Turvey et al. ,2000; Garvey and Milbourn, 2000; Keefand
Rush, 2003; Sparling and Turvay, 2003; Paulo, 2003; Threemanna and Gunaratne, 2015)who
have concluded in contrary to EVA proponents argument on the value relevance of EVA.
According to Peterson and Peterson (1996), the EVA type measures do not provide much
more information while Appleby (1997) have reported that the EVA is a measure which only
looks into a company’s historical performance where it provides no any indication of the
future performance of the company. In contrary to the EVA proponents’ argument, Turveyet
al. (2000) have reported that there is no any relationship between EVA and stock return.
Similarly, Keefand Rush (2003) too reported that EVA and Stock return shows no any
relationship. Further Keef and Rush (2003) have mentioned that the concept of EVA as an
enigma. Slightly different to Peterson and Peterson (1996); Appleby (1997); and Keef and
Rush (2003) findings on the relationship between EVA and stock return, Sparling and Turvey
(2003) have reported that there is a weak correlation between these two elements.
Though the reported results of the empirical studies which have been conducted worldwide
show large discrepancies, this concept has not yet been studied adequately in Sri Lankan
context. Kosalathevi (2013) has studied the impact of EVA on firm performance using data
from selected private banks in Sri Lanka and found that there is a relationship between EVA
and firm financial performance. However her study did not focus on the explanatory power of
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EVA on the stock returns. Threemanna and Gunaratne (2016) have studied the association of
EVA on stock return taking data only from the Beverage, Food and Tobacco sector
companies in CSE. The reported results of Threemanna and Gunaratne (2016) indicated that
the EVA is not a statistically significant performance measure which could explain stock
return in Sri Lanka. It was hard to find any other published work other than these two studies.
The discrepancies in the reported results of the relationship between EVA and stock returns
in the international context for both developed and emerging markets and the inadequacy of
the studies conducted in Sri Lankan context creates an obvious necessity to study this matter
further in Sri Lankan context for Colombo stock exchange. Accordingly the present study
was conducted to bridge the identified gap with the hypothesis that there is a strong positive
relationship between EVA and stock return in Sri Lanka.
The remainder of this paper has been organized as follows. The section 2 describes the
detailed analysis of literature and the section 3 explains the research methodology used in this
study. The section 4 describes the results and discussion and finally the conclusion of the
study is given in the fifth section.

2. Literature Review

The Economic Value Added is commercially developed in 1982 by the corporate advisory
team of Joel Stern and Stewart III (Grant, 2003) though the initial step of EVA was taken by
Stewart in 1974. As the value has become primary concern of the investors, the proponents of
EVA claimed that the EVA is a performance measures which tied directly to stock’s intrinsic
value (Stewart, 1991; Grant, 1996, 2003). Stewart (1991) has mentioned “Forget about
earnings, earnings per share, earnings growth, rate of return, dividends, and even cash flow.
All of them are fundamentally flawed measures of performance and value. EVA is all that
really matters”. Further Stewart (1994) argued that “EVA is almost 50% better than its
closest accounting based competitor in explaining changes in shareholder wealth.”
Finegan (1991) extended the initial analysis of Stewart (1991) by focusing the middle 450
companies in USA and have found that EVA outperformed the other performance measurers.
EVA showed 61 percent explanatory ability compared to 47 percent explanatory ability of
return on capital, the second best performance measure.
Grant (1996) too studied the association between EVA and MVA in US stocks and have
reported that EVA has proven to be a valuable analytical tool for corporate managers. EVA
has a significant impact on firm’s market value added (MVA). Further Grant (1996) found
that a fluctuation of EVA has a direct impact on the intrinsic value of firm’s outstanding debt
and equity securities. Grant (2003) validate the relationship between EVA and corporate
valuation using a sample of 983 US companies. He argued that EVA has a significant impact
on the MVA of a firm thereby supporting Stern Stewart hypothesis that EVA is superior
performance measure compared to traditional accounting based performance measures.
Lehn and Makhija (1996) studied the relationship between the performance measures and
stock returns using a sample of 241 US companies over the period from 1987 to 1993, and
the reported results are consistent with the Stewart (1991) claim on the superior explanatory
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power of the EVA on stock returns. O’Byrne (1996) found that EVA is systematically linked
to the market value unlike NOPAT or other earnings measures and further he argued that the
EVA is a powerful tool for understanding the investor expectations that are built into a
company’s current share price. Uyemura, Kantot and Pettit (1996) studied this taking data
from 100 largest US banks for ten year period from 1986 to 1995. The results depicted that
EVA is the performance measure that best correlated with the Market value added. The
findings of Uyemura, Kantot and Pettit (1996) lend the support towards Stewart (1991).
Milunovich and Tseui (1996) have found that EVA is more highly correlated with MVA.
Bacidoreat. el (1997) too found that EVA can be used in explaining stock returns. Girotra and
Yadav (2001) empirically investigated the EVA concept to find out its utility and limitations
in value based management framework in Indian context. In common with Stewart (1991)
they found that EVA has information content. Misra and Kanwal (2007) too studied the value
relevance of EVA in Indian context. Results of their study revealed that EVA is the most
significant determinant of MVA as it explains the variations in share value better than the
other conventional accounting based performance measures.
Irala (2007) revisited whether Economic Value Added has got a better predictive power
relative to the traditional accounting measures taking data from 1000 companies across 6
years. The reported results very much support the claim that the EVA is the better predictor
of market value compared to other accounting measures. Ismail (2008) revealed that EVA is
able to correlate with stock returns and is superior in explaining variations in the stock returns
in Malaysian context. Popa, Mihailescu and Caragea (2009) investigated the Romanian
Banking systems and have found that EVA can be an important tool that bankers can use to
measure and improve the financial performance of their bank. Haddad (2012) examined this
relationship in Jordanian banking sector. The results showed a positive and significant
relationship between EVA and stock returns. These results are consistent with the empirical
results provided on banking sector by Girotra and Yadav (2001), and Popa, Mihailescu and
Caragea (2009) for emerging markets. Further the results of Haddad (2012) are consistent
with the argument of Stewart (1991) on the superiority of EVA over traditional accounting
performance measures.
In contrary to the empirical evidence provided by the above studies on the positive
relationship between EVA and stock return and the support lend to the argument brought to
light by the proponents of EVA on the superior value relevance of the concept of EVA, many
other scholars have come up with different findings. There are numerous studies that have
argued that EVA is not superior to other measures and even it is not a significant performance
measure to be considered in decision making.
Chen and Dodd (1997, 1998);Biddle, Bowen and Wallace (1997);Worthington and West
(2001); Kim (2006); Ismail (2006) and Maditinos, Sevic and Theriou (2009) have reported
that though EVA shows a relationship with return, the EVA is not a superior performance
measure as argued by Stewart (1991) . Some other researchers (Peterson and Peterson, (1996);
Turvey et. al (2000); Keef and Rush, (2003); Sparling and Turvey, (2003); Palliam, (2006))
have concluded that the EVA does not have any correlation with stock returns, and the use of
such value based method is somewhat invalid and unreliable. Kramer and Pushner (1997)
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studied the effectiveness of the EVA as a proxy for MVA using the Stern Stewart 1000
companies for ten year period from 1982 to 1992 and have reported without lending any
support to the EVA proponents, that there is no any evidence to prove the superiority of EVA
over the traditional accounting performance measures. Kramer and Peter (2001) have
undergone inter industrial analysis using data from the Stern Stewart 1000 database and by
analyzing the data categorizing to 56 industries, they have not found any evidence to support
the superiority of EVA instead they have found that in most of the industries the marginal
cost of using EVA are not justified by any marginal benefits. Clinton and Chen (1998)
analyzed the relationship of EVA to stock price and stock returns selecting 325 companies
from Standard & Poor’s 500 and the Stern Stewart 1996 Performance 1,000 databases and
have found that EVA has no consistent significant association with either stock price or stock
return.
Biddle, Bowen and Wallace (1997) too examined the US market to tests assertions that
Economic Value Added (EVA) with stock returns and firm values. Further their study
extended to evaluates which components of EVA, if any, contribute to these associations.
Their conclusion is that, although for some firms EVA may be an effective tool for internal
decision making, performance measurement and incentive compensation, it does not
dominate earnings in its association with stock market returns for the sample firms and period
studied. Further Biddle, Bowen and Wallace (1998) argued that their independent
examination suggests that some of the claims over EVA are over stated while evidence
confirmed that managers respond to EVA incentives, there is no evidence thus far to support
claims that EVA is more closely associated with equity returns or firm values than is net
income.
DeVilliers (1997), DeVillers and Auret (1998) and DeWet (2005) among other have provided
contradicting conclusion on this regard in South African market. DeVilliers (1997) found that
EVA is not able to explain variation of stock return than accounting earnings. DeVilliers and
Auret (1998) found that EPS had more explanatory power than EVA in explaining stock
prices in South Africa. Gunter, Landrock and Muche (2001) examined this relationship in
German market and they too do not found any evidence to prove the superiority of EVA in
explaining stock returns in the context of Germany stock market. Worthington and West
(2001) found the same for Australian context and Peixoto (2002) for Portuguese public
companies listed on the Lisbon Stock Exchange. Ismail (2006) conducted a study and have
found that EVA is not a superior performance measure in UK context. Paulo (2010) too used
UK data to investigate whether the EVA is a superior financial performance metric as
claimed by Stern and Stewart Company and argued that there is no supportive evidence to
validate the claims of EVA. Kyriazis and Anastasis (2007) studied this for a sample of 121
non-financial publicly traded Greek firms listed in the Athens Stock Exchange and argued
that EVA does not appear to have a stronger correlation with firms' Market Value Added than
the other variables. The empirical results of Kumar and Sharma (2011a) too proposed that
EVA is not a superior performance measure in Indian market.
Despite the broad and contradicting literature available on the field of EVA stock returns in
international stock exchanges, the available knowledge on this context in Sri Lanka is very
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poor. It was hard to find published studies related to this matter other than Kosalathevi (2013)
and Threemanna and Gunaratne (2016).
Kosalathevi (2013) has studied the impact of EVA on firm performance using data from
selected private banks in Sri Lanka and found that there is a relationship between EVA and
firm financial performance. Her study too did not focus on the explanatory power of EVA on
the stock returns. Threemanna and Gunaratne (2016) have reported that EVA is not a
significant performance measure in explaining stock returns of Food Beverage and Tobacco
sector companies in Sri Lanka.
The above analysis of literature clearly shows that there is no conclusion on the relationship
between EVA and Stock return either in the international context or in the local context.
Hence it is worth to study the association between EVA and Stock return in Sri Lankan
context.

3. Methodology

3.1 Hypothesis

H0: There is no significant positive relationship between EVA and stock return in Sri Lanka
H1: There is a significant positive relationship between EVA and stock return in Sri Lanka

3.2 Population and sample

The population of the study is all the quoted Public Limited Companies (PLC) listed in the
Colombo Stock Exchange (CSE) Sri Lanka. The CSE has 295 companies representing 20
business sectors as at 31st August 2017, with a Market Capitalization of Rs. 2,897.7 Bn.
The sample size of this study was 1695 firm year observations obtained from 113 public
limited companies registered in CSE and the sample period spans for 15 years from the year
1998/1999 to the year 2012/2013. This sample was selected using five criterions. The first
criterion is how long the company is trading in the CSE. As the sample period spans for 15
years from the year 1998/1999 to 2012/2013, any public limited company quoted on or
before 1/4/1998 and operates continuously for 15 years period are qualified to consider in the
sample of this study. But to calculate the variables under the study it is required to use the
data of two prior years’ to the sample period. Hence it was required to consider only the
companies quoted on or before 1/4/1996 and operating 17 years continuously. The second
and third criterion was to exclude the companies registered under the Bank Finance and
Insurance sector and Diversified Holdings sector from the sample. The Bank Finance and
Insurance sector companies were removed due to the inherent conditions of financial
institutes compared to the companies in any other sectors in CSE. This exclusion is
empirically supported by the Fogelberg and Griffith (2000) and Bandara and Weerakoon
(2011). The forth criterion is the balance sheet date (financial year end) of the companies.
The researcher considered only the companies whose financial year ends as at 31st March
each year. Hence the researcher removed all the companies whose financial year ending any
dates other than 31st March from the sample of this study. The fifth and last criterion is the

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availability of all the required data for entire 17 years period to have a strongly balanced
panel data set. There were only 113 companies satisfied all five criterions.

3.3 Data and data collection

The entire study was based on secondary data. The required secondary data was collected
from two main sources namely the data library of the CSE and the published financial
statements of the companies considered in the sample of the study. Finally the relevant
calculations were made by the researcher using Excel worksheets to derive the variables used
in this study.
3.4 Variables definition and calculation
The dependent variable of the study is annual stock returns of the companies listed in CSE.
The stock return calculation was based on the mostly applied reinvestment assumption. All
the types of remittances such as Dividend Payment, Bonus Issues, Stock Splits and Right
Issues were considered for the calculation of Stock return. As per the Ph.Dthesis of Nimal
(2006) the following formula was used to calculate the monthly returns of each company.

 P P (1 + R r + S r + B r + D r )  
Rit =  t c  − 1 × 100
  P0 ( Pc + R r Pr )  

Where;
Rit : Return of the stock i in the month t
Pt : Price of the stock at the end of the month t
Pc : Closing price of the stock on Ex-right date/ the stock price immediately before the
ex-right date
Rr : Right ratio
Sr : Split ratio
Dr: Dividend ratio
Br: Bonus Ratio
P0: Price of the stock at the beginning of the month t
Pr: Right issue price of a stock
Finally the annual returns were calculated as the aggregation of the monthly returns
extending nine months prior to the fiscal year end and three months after the fiscal year end.
(ex. Return of the Year 2012/13 was calculated by aggregating the returns of April 2012 to
March 2013).
The independent variable of this study is EVA. As the study used Easton and Harris (1991)
formal valuation model both EVA and change in EVA (ΔEVA) need to be calculated for the
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study. Stewart (1991) calculated EVA by deducting a cost of operating capital from net
operating Profit after Tax (NOPAT- Cost of Capital). Obtaining NOPAT figures of Sri
Lankan companies is much difficult since it is not published. Pandey in his book financial
management 9th edition has stated that EVA is defined as net earnings (PAT) in excess of the
charges (cost) for shareholders’ invested capital (Equity). Further Fraker (2006) and Bandara
et al (2008) have used PAT instead of NOPAT in calculating EVA. Therefore in this study
the EVA of each company was calculated by deducting the cost of equity from the profit after
tax (PAT). This figure represents the EVA contribution only for the equity shareholders.
The equation used to calculate EVA could be stated as follows.
EVA= PAT – (Ke*TE)
Where;
EVA : Economic Value Added
PAT : Profit after Tax
Ke : Cost of Equity
TE : Total Equity
The Capital Assets Pricing Model (CAPM) of Sharpe (1964) was implemented to calculate
cost of equity (Ke). Accordingly the cost of equity was calculated by using the following
equation.
Ke = Rf+ βi (Rmt - Rf)
Where,
Ke : Cost of equity
Rf : Risk free rate

β i : Beta coefficient

Rmt : Market rate of return

Three hundred and sixty five days Treasury bill rate was considered as the risk free rate.
The beta coefficients for each company for each year were estimated by using 36 monthly
returns employing regression technique. The slope of the regression line of following
equation was considered as stock’s beta coefficient.
Rit = α i + β i Rmt + eit
Where,

Rit : The periodic return for the firm j in time t

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αi : The constant term

βi : The estimated beta (systematic risk) for the firm for the year

Rmt : The periodic return for the market index

eit : The random error term whose expected value is zero

The periodic return of the market index (Rmt) was calculated using the all share price index
(ASPI) data. The formula used to calculate the market return can be shown as follows.

P − P 
R = t 0  × 100
mt  P
 0 

Where,
Rmt : Market Return in the month t
Pt : All Share Price Index of end of the month t
P0 : All Share Price Index of beginning of the month t
Change in Economic Value Added (∆EVA)
The ∆EVA indicates the annual growth or decline in net earnings in excess of cost of capital.
The ∆EVA was calculated in this study as the quotient of the difference between the two
consecutive observations (EVAt - EVAt-1) dividing by the previous time period observation
(EVAt-1). Accordingly the following formula was used to calculate the ∆EVA.
∆EVA = ( EVAt - EVAt-1) / EVAt-1
3.5 Data analysis techniques
This study used correlation coefficient analysis and regression analysis techniques to analyze
the collected data in order to achieve the research objective. As the panel data analysis
endows regression analysis with both a spatial and temporal dimension, this study used panel
data regression analysis technique.
The appropriate panel data regression model for the collected data was selected by
performing three tests, Fisher F test, Lagrange Multiplier (LM) test and Hausman
specification test. The F test recommends the best panel model out of pooled data regression
model and fixed effect model while the LM test recommends the best model out of pooled
regression model and random effect model. The Hausman specification test compares the
fixed effect model and the random effect model. Further the researcher used Easton and
Harris (1991) formal valuation model in this study. According to that model the following
regression model was developed and tested using panel data approach in this study.
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Rit= at0 + a1EVAit/pit-1+ a2∆EVAit/Pit-1 + eit

Where;
Rit = The annual compounded returns for firm i time t.
EVAit = Economic Value Added of firm i time t
ΔEVAit = Change in Economic Value Added of firm i time t
Pit-1 = The market value per share of firm i at the first trading day of the ninth
month prior to fiscal year end
This regression equation was tested for multi-colinearity using variance inflation factor (VIF)
analysis. Further the researcher conducted Harris- Tzavalis unit root test and Breitung’s unit
root test in order to test whether the data set of this study consists of unit roots.

4. Results and discussion

This study was conducted to investigate whether the EVA is a significant performance
measure in terms of explaining stock returns in Sri Lanka. The person correlation coefficient
analysis was used to identify the relationship between EVA and stock return in Sri Lanka.
The results of the correlation analysis are shown below.
Table 1. Pearson Correlation Coefficient

Variable Return EVA ΔEVA

Return 1
EVA 0.0317 1
ΔEVA 0.0324 0.1674*** 1
N.B: The correlations between each pair of variables were measured at 10 percent, 5 percent
and 1 percent significant levels. The resulted correlation coefficient values that are significant
at the 1 percent level have been marked with *** , significant at 5 percent level have been
marked with ** and significant at 10 percent level are marked with *.

The results of the Pearson correlation coefficient analysis presented in table 1 above clearly
shows that both EVA and ΔEVA have positive correlation with stock return but the value is
very low (week positive correlation). However this relationship is not statistically significant
as the P values of both EVA and ΔEVA are greater than 0.1 level.
Even though the relationship between EVA and stock return identified through correlation
coefficient analysis was not significant, the researcher further analyzed this using panel data
regression approach. The most suitable panel data regression model for the current data set
was fixed effect regression model. Hence the researcher tested fixed effect regression model
and the results obtained were depicted below.
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Table 2. Fixed effect regression model of EVA and stock return

This table shows the result of the panel data regression analysis conducted to test the
significance of EVA in explaining Stock Return. Further to check the existence of
multi-colinearity among variables, the Variance Inflation Factor (VIF) analysis was
conducted and the relevant VIF values have been presented in the same table.

Variable Coefficient Robust P- value VIF

Standard
Error

Constant 37.4498 .2823596 0.000

EVA 1.63e-07 1.77e-07 0.357 1.03

∆EVA 8.65e-07 4.90e-07 0.080 1.03

Sigma u 28. 022576

Sigma e 92.183593

Rho 0.0846

R2 0.0017

VIF > 10 indicates presence of multi-collinearity.

Rit = 37.4498 +1.63e-07 EVA + 8.65e-07∆EVA

The table 2 presents the results of the estimated fixed effect regression model which was
regressed on the stock returns (dependent variable) with the EVA and ΔEVA to test the
hypothesis that there is a significant positive relationship between EVA and stock returns in
Sri Lanka. As per the results presented in the table the researcher failed to reject the null
hypothesis in favour of the alternative hypothesis. Hence it was failed to prove that the EVA
is a significant performance measures in explaining the cross section of stock returns in Sri
Lanka. The results revealed that the model could explain only a 0.17 percent return variation.
The intra-class correlation known as rho is 8.5 percent which is the variance due to the
differences across companies and the total variance due to cross sections is (sigma u) 28.02
percent.

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5. Conclusion

This study examined the relationship between EVA and stock return in Sri Lanka taking data
from 113 public listed companies in CSE. The results of the study revealed that there is no
significant positive relationship between EVA and stock return in Sri Lanka. Both the EVA
and change in EVA shows a weakly positive relationship in the Pearson correlation
coefficient analysis where the relationship was not statistically significant as the P value was
greater than 0.1 level for both EVA and ΔEVA. The panel data regression analysis too
evidenced that there is no statistically significant positive relationship between the
independent and dependent variable as the results revealed that only 0.17 percent return
variation could be explained by EVA. Accordingly, in Sri Lankan context the EVA is not a
suitable performance measure to be used in explaining stock returns in the companies whose
stocks are traded in the CSE. Hence the researcher recommends the market participants to use
any other technique/(s) in making the respective decisions in Sri Lankan context.
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